Merrill Lynch & Co.

Four days before Merrill Lynch & Co. stopped supporting the auction-rate securities market and left thousands of individual investors stuck with securities they couldn't sell, the firm's analysts recommended clients buy.

``Reports of the imminent demise of the auction market seem to be greatly exaggerated, again,'' analyst Kevin Conery wrote in a Feb. 8 research note. ``We continue to be impressed by the auction market's resiliency.''

The remarks show Merrill's researchers were ``co-opted'' during a seven-month drive by the New York-based firm's sales force to prevent a meltdown in the $330 billion market, Massachusetts Secretary of State William Galvin alleged yesterday in an administrative complaint filed in Boston. As the sales desk pushed analysts to publish upbeat notes, managers used gallows humor to complain about a ``collapsing'' market and the end of $2,000 dinners.

``Come on down and visit us in the vomitorium!!'' the auction-rate desk's managing director, Frances Constable, wrote to a co-worker in August, as demand began to dry up. ``Market is collapsing,'' another executive cited in Galvin's complaint said in a November 2007 personal e-mail. ``No more $2K dinners at CRU,'' a Manhattan restaurant where the wine list includes dozens of bottles for more than $1,000.

Galvin, 57, wants the third-largest U.S. securities firm to ``make good'' on sales of now-frozen holdings, compensate investors who disposed of their bonds or shares at a loss and pay an unspecified fine. He has already filed a related claim against Zurich-based UBS AG, and is probing Bank of America Corp.

`Significant Danger'

``Research analysts routinely soft-pedaled significant negative events affecting liquidity in the auction markets,'' he said in the complaint. At the same time, managers knew ``the auction markets were not functioning properly and were in fact in significant danger of collapsing,'' he said.

Conery, 47, received a ``six-figure'' bonus for 2007 after his year-end review credited him for ``proactive and timely interchange'' with the sales desk and clients, according to the complaint. ``Ultimately, his work contributed to better liquidity and lower inventory levels in the marketplace,'' the reviewer said.

Merrill denied that its analysts acted improperly in recommending auction-rate securities, also known as ARS.

The analysts mentioned in Galvin's complaint ``are men of integrity and intellectual honesty. They called the ARS market as they saw it, not the way anyone else did,'' Merrill spokesman Mark Herr said. ``Nothing the sales desk could do or couldn't do affected how much these analysts earned or their standing in our research department.''

Pulling Support

Auction-rate securities are long-term bonds or preferred shares with interest rates adjusted typically every seven, 28 or 35 days through a dealer-run bidding process, providing them with the characteristics of money-market investments. Firms historically supported the auctions, without contractual obligation, when demand waned.

Merrill is the second bank to face a complaint by Galvin after brokers stopped supporting the auctions in mid-February as losses from securities tied to subprime mortgages mounted. Massachusetts last month filed a complaint against UBS, Switzerland's biggest bank.

UBS said it will contest the allegations. The bank agreed July 30 to pay $1 million to settle a separate complaint filed by Massachusetts Attorney General Martha Coakley over the marketing of auction-rate securities to 20 towns and public agencies in the state. UBS also agreed to pay $38.5 million to the municipalities.

Insurer Losses

February's meltdown began in July 2007, when MBIA Inc. and Ambac Financial Group Inc., the two largest insurers of auction- rate debt, reported lower profits because of losses on securities backed by subprime mortgages. Losses at the insurers prompted auctions for $1.8 billion of their own securities to fail, according to Fitch Ratings.

That month, Constable, 51, objected to an analyst's report, which noted auction-rate bonds lack a so-called ``hard put,'' like some other variable-rate securities, which obligate the issuer to arrange a purchaser for any unwanted securities when rates reset.

The reference was misleading, she said, because the report focused on municipal bonds and those instruments weren't yet failing. When the analyst, Martin Mauro, refused to retract the note, Constable sent an e-mail to colleagues within the firm.

``I HAD NOT SEEN THIS PIECE UNTIL JUST NOW AND IT MAY SINGLE HANDEDLY UNDERMINE THE AUCTION MARKET,'' she wrote in capital letters, according to Galvin's claim.

`Misplaced' Concerns

The research department withdrew the report a day later, Galvin said. While a revised version still included information on the hard put, it also recommended auction-rate securities, saying concerns were ``misplaced'' and they may offer good value.

``The same facts contained in the first report were all retained in a longer, fuller and clearer version,'' Herr said.

Constable, Conery and Mauro, all located in New York, have no comment, he said, declining to make them available. They aren't named as defendants in Galvin's complaint.

Constable's objections had a lasting effect, according to Galvin. When an analyst drafted a report on the securities the following January, he asked his colleague for advice before publication.

``I want to make sure that research cannot be accused of causing a run on the auction desk,'' the analyst, who wasn't named, wrote in an e-mail. » link